Investing in Penny Stocks: Understanding the Risks

Micro-cap, nano-cap, penny stocks… whatever you want to call them- they’re a hot commodity for traders looking for a little thrill in their investment strategy.
Yes, penny stocks are a much higher risk than regular stocks and you absolutely need to know a few things before dipping your fingers into such a game.

For the purpose of this post, I will consider a penny stock to be any stock that is trading at less than $5/share. Some consider them to only be ones trading at less than $1, but I find that too limiting in scope, especially considering the risks I’ve outlined below.

The major risk factors you need to consider. Don’t get me wrong, investing in small companies is a great way to make a lot of money, afterall every trader knows the easiest way to make a HUGE amount of money fast is with penny stocks. You must, however, understand and feel comfortable with all the risks before deciding to put ANY money in penny stocks. After all, with opportunities for big gains come an equal likelihood of big loses.

The risks you need to consider are:

Lack of History and Information
Companies selling penny stocks are often fairly new. You have a little financial history to take a look at, the management team may be fairly new so you cannot get a good idea of their capabilities and you’re unsure if their competitive advantage and true market value is really worth the price you’re about to pay. Feel comfortable knowing you don’t have enough information and look for growth catalysts that cement or clarify the companies vision and future.

Low Level of Liquidity
If there is a low level of liquidity you may have a hard time finding a buyer for that particular stock and so you can be forced to lower your price of the stock, selling for less than you paid for. When low liquidity levels occur, you will also find that the price can more easily be manipulated. Crafty investors with a lot of money will buy a large amount of stock, hype it up (social media and the internet make it so easy to do this) and then sell it for more than they were originally asking for.

OCTBB and Pink Sheet LLC
Stocks on the OCTBB (Over-the-counter Bulletin Board) or on Pink Sheet LLC have less requirements than regular stocks to stay on the exchange. For that reason it is entirely possible to wind up investing in a company that drops 25, 50 or 100% over night. While the OTCBB requires that companies fill out timely documents with the SEC, Pink Sheet LLC does not.

Percentage of Failures
Companies trading on the OTC are generally in one of two positions. They either are newly formed and trying to rapidly grow… or their about to head into bankruptcy. Either way, there is little information available and the number of companies that succeed in this area are small. Get comfortable with this risk, believe in the idea you’re investing in and go along for the ride.

Understanding the risks associated with penny stocks and deciding that you’re comfortable with them is the first step to getting ready to trade. This is a risk you’re taking for a big reward. Good luck ☺